BBRT - Beyond Budgeting Roundtable By Marc Hodak*
Jack Welch retired with few complaints. But while he was still CEO of GE, he had a particular peeve regarding the annual planning process: “Making a budget is an exercise in minimization. You’re always getting the lowest out of people, because everyone is negotiating to get the lowest number.”
Welch was deeply frustrated by what he considered puzzling behavior: each fall, he would witness highly talented, Type-A, “can do” personalities suddenly, temporarily transform into world-class excuse-mongers, passionately defending modest projections of mediocre performance.
Underlying this apparently paradoxical behavior is missing an element in how companies think about planning and budgeting. Most companies think of effective planning as centered on accurate forecasting and powerful analysis yielding compelling insights. They believe that if they can better predict the future, and better model their organizational responses to alternative scenarios, they can better allocate their resources to position themselves to take advantage of opportunities. Companies invest a lot of time, energy, and funds on various analytical methods, or systems that enable them to gather more and better data, and crunch it more thoroughly and usefully. They try to update their plans to stay more current with changing conditions, even going to rolling plans.
But Welch’s complaint wasn’t with the quality of his units’ forecasts, or the relevance of old plans to changing conditions. Welch’s complaint was that he was being sandbagged in the planning process itself. There is no analytical solution to this problem because its root cause is not informational deficiency, but informational asymmetry. Senior managers hold the purse strings, and the expectations of their boards and investors. Business unit managers hold the information needed to intelligently plan, and their boss’s expectations, which they can significantly manage using their superior information. Neither side can have what the other has.
The solution to this problem is not higher-powered number-crunching tools or more frequent updates, but altered incentives on one or both sides of that asymmetry. Welch’s hope was not a better way to negotiate budgets, but an end to the negotiation. He wanted managers to spontaneously propose aggressive goals, without his prodding, because that’s what the owners would do if they were managing each business directly.
The root cause of Welch’s complaint is perhaps the most common practice in corporate compensation: the use of budget goals as incentive plan targets. There are many reasons why this practice creates perverse incentives. Anyone who has been through a budgeting cycle immediately understands how the prospect of having your budget targets translated into incentive plan targets literally pays us to understate the true potential of our business. This is not good for the company.
Aside from the “negotiation to the lowest” phenomenon, budget-based incentive targets also discourage performance significantly beyond one’s “maximum” or “stretch” targets. These targets frequently represent the point beyond which no further bonuses are awarded, i.e., a bonus cap. It’s bad enough that you might find yourself above the bonus cap, a region of unrewarded performance, but blowing by the goal associated with that cap also risks raising difficult questions about how much you sandbagged your budget last year. Such questions are often answered by having your boss imposing much higher targets the next year. Who needs that? In this way, budget-based compensation targets create an incentive to underperform the understated potential of one’s business.
An irony of “stretch targets” is that corporate leaders hail them as an effective way to get the best out of their people. (You can just hear Jack say, “C’mon. Show me what you can do!”). Once one understands the incentives of the planning process, one can see that the need for corporate executives to demand stretch targets is just another illustration of the failure of the negotiated budget model.
In many cases, the perverse incentives built into most planning processes are there simply because that’s the way the planning process evolved in most corporations. For a significant number of companies, however, those incentives are there for a more conscious, insidious reason. The budget process maintains a level of control (or the illusion of it) firmly in the hands of top management. When it’s explained to them how budget-based compensation targets create sandbagging behavior, a fair number of CEOs say they’re fine with that. Why? Because they aren’t using the planning process as a process of discovery—they’re using planning (and budgeting) as a means for control. They believe that tying budgets to compensation gives them more control of their managers, and therefore more control over corporate results. For top executives who believe that their path to maximum performance is via centralized control, changing incentives to liberate the planning process, even to create more aggressive goals, is simply a challenge to their authority.
The success of the LBO (leveraged buy-out) movement and the growth of private equity-backed firms in buying up pieces of giant companies, are due, in part, to their liberation of significant assets from this corporate budget process.
All this is not to say that budgets in the form of financial plans don’t serve a useful purpose. It’s difficult to run a business without a financial plan. The point is that the use of annual budget targets as compensation targets corrupt the budget process and encourage mediocrity. Fortunately, there are ways of dissociating the planning and budgeting process from the establishment of incentive plan targets. Some companies have begun to adopt “investor-derived” target setting mechanisms. One can analytically determine a plausible range of expected profit growth from current market values of public companies. Our firm and others have developed clever ways of translating those “observable” profit growth estimates into incentive plan targets that satisfy managers, boards of directors, and investors. Similar methods have been adapted to the private company world, whereby compensation targets can be derived from the investment thesis of a private acquirer, or via a “continuous improvement” mechanism in firms owned by families or large institutional shareholders. These tools are fairly sophisticated, and may not work for every firm, but experience is showing that the vast majority of companies may be able to abandon the counterproductive practice of budget-based incentive targets using these newer methods.
It’s difficult to quantify the penalty paid by firms who engage in budget-based target setting because the practice is so prevalent. One place to look would be the performance of public companies or divisions that have gone through an LBO or private equity purchase, only to be resold later at huge profits. Another indicator might be firms that base their bonuses on avowedly subjective factors. In other words, they don’t derive their targets from budgets. Perhaps the compelling pattern of out-performance of such firms, contrary to the expectations of most governance experts, might be an indication that objective, budget-based targets inhibit significant growth. Fortunately, we don’t need to resort to the harsh discipline of an LBO, or subjectivity in lieu of budgets to set appropriate targets. A growing number of companies comfortably set targets based on year-over-year improvement, or expected improvement derived from market data.
*Marc Hodak is Managing Director of Hodak Value Advisors, a firm specializing in performance management, incentive compensation, and governance. Marc teaches corporate governance at New York University’s Leonard N. Stern School of Business. He can be reached at mhodak@hodakvalue.com.
